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Herbalife Doesn’t Come Up Short – Yet

By Robert Frick on July 19, 2016

Sometimes a short seller can’t catch a break. You’d think that a company’s stock would drop when it admits to the Federal Trade Commission that it’s been manipulating customers, will pay a $200 million fee and will enact draconian changes to its business to reduce this deception.

But that’s the story of Herbalife, and news last Friday that it had settled with the FTC sent the shares skyrocketing 22% to a 2 year high of $72 before settling down to a 10% gain for the day.

The short seller, who was betting big on Herbalife crashing, was Bill Ackman of Pershing Square Management. Ackman has been leading a crusade against Herbalife (NYSE: HLF) since 2012.

Ackman shouldn’t feel too badly. I spent years of my career researching short sale candidates, and as I noted last spring in my piece about Sam Adams (“Sam Adams Running Dry,” April 2016), being correct on the fundamentals of a short story is only half the battle. The victory comes only when the price of the stock collapses enough to generate a profit for the short seller.

Ackman is no dummy. He did some serious homework and has a team of super bright analysts chasing down the workings of Herbalife. But he’s yet to rake in a big profit despite the FTC mostly agreeing with his analysis.

Ackman’s story  is a cautionary tale, and timely for me as I’ll be issuing some short recommendations (via puts) in my Profit Catalyst Alert newsletter in the near future. 

Pyramid or Just Misleading?

Herbalife sells dietary and nutritional supplements, protein shakes and snacks, mostly geared towards weight loss. Instead of using traditional retail channels, Herbalife sells its products through a network of distributors. Each distributor, typically an individual working from home, can earn extra commissions by recruiting new distributors. The business has some of the markings of a pyramid scheme. In such a scheme, a business can grow only if new distributors are added, and eventually must collapse. A pyramid scheme is illegal.

Ackman pounced on Herbalife with a scathing and public campaign. In December 2012 he announced a $1 billion short bet against the company. His epic presentation included a 3 hour, 342 page slide deck detailing his short thesis on Herbalife.

Part of the problem is that Herbalife rarely missed Wall Street estimates and always produced a profit. The stock was never expensive. Bill Ackman’s short was predicated on Herbalife being found guilty of fraud.

The FTC had some pretty harsh words for Herbalife, blaming the company of “deceiving hundreds of thousands of hopeful people” with the belief they could get rich. Yet it stopped short of shutting the company down. Edith Ramirez, the FTC chairwoman, said “This settlement will require Herbalife to fundamentally restructure its business so that participants are rewarded for what they sell, not how many people they recruit.”

Run For Cover?

The interesting thing to me is that Herbalife might be a better short now than at any other time. The company’s hands are tied regarding its marketing and recruitment schemes that bloated revenue. Now that the FTC is breathing down its neck, Herbalife’s profits might finally give the shorts a healthy dose of missed expectations and shrinking profits.

 


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